Zacks Small Cap Institutional Research



|Icos Corp. |(ICOS - NASDAQ) |$33.73 |

Note to Reader: All new or revised material since the last report is highlighted.

Reason for Report: Revised Merger Agreement with Lilly Prev. Ed.: November 14, 2006

Overview

ICOS Corporation (ICOS), based in Bothell, Washington, is a biotechnology company engaged in the discovery, development, and commercialization of therapeutic products. It markets Cialis (Tadalafil) for the treatment of erectile dysfunction through its joint venture with Eli Lilly in North America and Europe. The company develops and commercializes treatments for serious unmet medical conditions such as chronic obstructive pulmonary disease (COPD), benign prostatic hyperplasia (BPH), cancer and inflammatory diseases.

The future of Icos Corp. relies heavily on Cialis, highly touted as a blockbuster drug for male erectile dysfunction. Co-marketed with Eli Lilly, Cialis has a billion-dollar potential, thanks to both stronger acting and longer lasting efficacy relative to Viagra. Additionally, the drug should have less harsh side effects. The analysts are, by and large, bullish about the potential for Cialis, even though it is the third erectile dysfunction drug to come to the market behind market leader Viagra and Levitra.

Analysts have identified the following factors for evaluating the investment merits of ICOS.

|Key Positive Arguments |Key Negative Arguments |

|Analysts believe Cialis, a relatively new drug for male erectile dysfunction,|Gain in profitability given short-term reductions in marketing spend could |

|has a billion-dollar potential. |adversely impact the long-term growth potential of the company. |

|Data provided by the company shows Cialis has both superior efficacy and |ICOS is difficult to value given the significant net loss and lack of |

|lower incidence of side effects than Viagra and Levitra. |visibility into just how much of the worldwide ED market share Cialis will |

| |capture. |

|ICOS is aggressively pursuing label expansions for Cialis in BPH, PAH and |Recent prescription sales trends indicate flat growth for |

|hypertension. These markets are large, and Cialis has generated positive |PDE-5 inhibitors, which is the drug class that includes Cialis, Viagra, and |

|clinical data in all three indications. |Levitra. If the overall target market for Cialis flattens, this could have |

| |negative implications for ICOS's growth prospects going forward. |

The company’s website address is . Its financial year ends on December 31.

Recent News

On December 18, 2006, ICOS announced that it has revised its merger agreement with Lilly to reflect a purchase price of $34 per share, up from the prior offer of $32 per share. On December 14, 2006, ICOS provided financial guidance for 4Q06, FY06 and FY07.

Revenue

Cialis

Indication: Erectile dysfunction (ED)

Product Life Cycle Position: Mature; widely sold and distributed.

Importance: A key driver of revenues and the product continues to perform well. Cialis is the only PDE-5 inhibitor, which has been steadily gaining market share ever since its launch. Analysts attribute this steady gain in market share to the product’s superior and differentiated profile. Further, results from a recent study indicate that Cialis could be used in the benign prostatic hyperplasia (BPH) indication. If successful, it could effectively remove two major hurdles for the ED market, a reluctance to see a doctor, and patient reimbursement.

Sales: LLY/ICOS reported 3Q06 total revenues of $201.5M, up 24% YoY. Worldwide sales of Cialis in 3Q06 totaled $245.6M, with $115.1M in North America ($94.9M in the US), $75.5M in Europe and $55.0M in non-JV territories. Global sales increased 26% YoY.

According to the Zacks Digest report, 3Q06 US sales were $94.9M, up 22.5% YoY, EU sales were $75.5M, up 21.7% YoY and ROW sales were $55.0M, up 34.8% YoY. One firm (BMO Capital) expects international growth of Cialis to benefit from continued market growth, share gains and modest price increases, as well as an upcoming approval in Japan (expected in 2007).

Drawback(s): The analysts, in general, are worried about lower-than-expected growth of the ED market. Moreover, Cialis is priced at $10.0 to $13.0 — a substantial premium over other approved medicines for BPH selling at $1.78 to $2.85. Management indicated that the 5-mg dose would prove to be effective and, therefore, it would be able to price the drug at a level more comparable to the currently marketed BPH drugs.

Safety Issues: Cialis can cause blood pressure to drop suddenly to an unsafe level if it is taken with certain other medicines (called nitrates).

Regulatory Issues: On June 7, 2006, ICOS announced that Lilly ICOS LLC, its joint venture with LLY has submitted a regulatory filing for marketing approval to the EMEA for Cialis (Tadalafil) 2.5 mg and 5 mg once-a-day dosing to treat erectile dysfunction (ED). The EMEA filing followed the completion of three Phase III clinical studies that evaluated the efficacy and safety of Cialis when administered once-a-day for the treatment of ED. Management has indicated that it expects approximately 10% “on demand” patients to switch to once daily regimen.

Competitors: Viagra (PFE), Levitra (GSK/Bayer). The FDA granted permission to LLY/ICOS to remove the warning from the Cialis label that prevents Cialis’s use with alpha-blockers. The warning will now appear in the precautionary section instead, similar to the labeling for Viagra and Levitra.

Partners: Eli Lilly (LLY) is the marketing partner. ICOS and LLY entered into a joint venture (JV) to co-promote the drug in the US, Canada, Mexico, and the EU. LLY has exclusive rights to market Cialis in all other parts of the world, and pays Lilly ICOS JV a royalty of 20% of net sales in those territories. ICOS is entitled to 50% share of the profit.

Additional Indications: Tadalafil (Cialis) has four potential uses (1) erectile dysfunction, (2) pulmonary arterial hypertension (PAH), (3) benign prostatic hyperplasia (BPH), and (4) hypertension. At present, Tadalafil is the only approved drug for erectile dysfunction. The company is in early Phase III testing for pulmonary arterial hypertension, late Phase II testing for benign prostatic hyperplasia (BPH), and Phase II testing for hypertension. Analysts stated that although Cialis’s potential outside the ED indication was promising, any meaningful use was still several years away.

Additional Studies: ICOS and LLY are working on a new indication, viz. BPH to drive growth outside the ED market. BPH is a disease associated with an enlarged prostate gland that affects over 3M men in the US and EU each year. Preliminary Phase II results of the study of Cialis in treatment of BPH have shown a clinically meaningful and statistically significant improvement in lower urinary tract symptoms versus placebo over a six-week period. However, the duration of efficacy for Cialis is unknown. The FDA has requested a dose-ranging Phase IIb study of Cialis in BPH before the initiation of formal Phase III trials in 2007 (delayed from previous expected schedule of 2006). LLY/ICOS intended to initiate a Phase IIb, multi-dose, 12 week trial by middle of 2006. The company announced that it would begin dosing the study later in 2006. However no update on this was provided by the company, during 3Q06 earnings call. This study could serve as one of two required pivotal studies, and the company could be in Phase III in 2007.

ICOS has advanced into Phase III testing for treatment of pulmonary arterial hypertension (PAH) in a study of 400 patients. The randomized, double-blind, placebo-controlled study will assess the effects of Tadalafil on 6-minute walk test after 16 weeks of treatment. Pfizer recently received final approval for Sildenafil for PAH under the brand name Revatio.

Management is conducting a 171-patient Phase II clinical trial of Cialis for treating mild to moderate hypertension with both 5mg and 20mg daily doses over an 8-week period. The primary endpoint of the study will be for a mean change in diastolic and systolic blood pressure after 8 weeks. Data should be forthcoming in 2H06. Analysts, in general, believe that given the stagnancy of the ED market, label expansion into other indications will be critical for long-term value as mere share gains in erectile dysfunction might not be enough to drive meaningful growth.

|Cialis |2005A |2006E |2007E |2008E |CAGR (’04 – ’07) |

|Canada + Mexico Sales |$59.4M |$75.5M |$89.0M |$102.0M |34.0% |

|E.U. Sales |$244.5M |$290.8M |$324.5M |$369.4M |22.2% |

Pipeline drugs

Following the decision to stop the development of its PDE-4 inhibitor in March 2005, the recent failure of the Phase II trial on IC485 for COPD is another setback. This was the most promising candidate in clinical trials besides Tadalafil. The company was looking to access the multimillion dollar COPD market with IC485, but the recent failure forces it to focus on its pre-clinical compounds to strengthen its product pipeline. This means the company has further delayed the possibility of bringing a product into the market. It currently has no major growth drivers besides Cialis and, therefore, needs to strengthen its pipeline. Current drug development programs are generating little excitement.

Collaboration Revenue

According to the Zacks Digest report, Collaboration revenue in 3Q06 was $16.4M, up 20.25 YoY as compared to $13.6M in 3Q05. The company stated that the increase was primarily due to reimbursable costs of 40 contract (non-employee) sales representatives retained to promote Cialis in the U.S. beginning in January 2006.

Financial Guidance

ICOS provided 4Q06, FY06 and FY07 guidance on December 14, 2006. The company expects 4Q06 Cialis sales to range between $255 million - $265 million, net income of $11 million - $15 million, and diluted EPS of $0.17 - $0.22. For FY06, the company expects Cialis sales of $955 million - $965 million, net income of $21 million - $25 million, and EPS of $0.33 - $0.38.

For FY07, ICOS expects worldwide Cialis sales of $1,100 million - $1,150 million, net income of $52 million - $63 million, and EPS of $0.78 - $0.94. One firm (BMO Capital) believes the financial guidance fully reflects the underlying earnings power of Cialis.

| |2005A |2006E |2007E |2008E |CAGR (’04-’07) |

Margins

According to the Zacks Digest report, gross margin in 3Q06 was 87.1% up 800 basis points YoY as compared to 79.1%. Net income in 3Q06 was $11.1M, up 197% YoY as compared to a loss of $11.5M in 3Q05.

ICOS’ 50% share of LLY/ICOS earnings was $40.0M in 3Q06, compared to $10.0M in 3Q05. The company attributed the $30.0M improvement to growth in the sales of Cialis around the world and planned reductions in marketing and selling expenses.

According to the Zacks Digest report, R&D expense in 3Q06 was $24.2M, up 13.1% YoY as compared to $21.4M in 3Q05. SG&A expense in 3Q06 was $20.4M, up 26.2% YoY as compared to $16.2M in 3Q05. ICOS reported 3Q06 total operating expenses of $51.3M, compared to $49.9M in 3Q05. Operating expenses for 3Q06 include $5.4M in stock option expense.

|2006E: |Gross Margin |R&D |SG&A |

|Digest Average |86.5%↓ |$100.0M↓ |$84.6M↓ |

Earnings per Share

According to the Zacks Digest report and ICOS, pro forma EPS in 3Q06 was $0.15, up 181% YoY as compared to loss of $0.18 in 3Q05. Analyst believes that the strong growth was largely due to increased Cialis revenue in 3Q06 and continued operating expense management undertaken by LLY and ICOS. According to the Zacks Digest report, GAAP EPS for 3Q06 was same as pro forma EPS of $0.15.

| |2006E |2007E |

|Digest Average |$0.39↑ |$0.83↑ |

|Company Guidance |- |- |

|High Estimate |$0.39↑ |$1.28↑ |

|Low Estimate |$0.23 |$0.16 |

For further information please refer to ICOS.xls file.

Target Price/Valuation

Target price for ICOS ranges from $32.00 (BMO Capital, Zacks Investment Research) to $36.00 (McAdams, UnionBankSwitz.). Most of the firms in the digest group have used forward EPS estimate to derive the target price. The Digest group now predicts an average price target of $34.00 (↑ from previous report). Of the seven analysts currently covering the company, five have assigned Neutral ratings, and two have assigned negative ratings. None of the firms has assigned a positive rating.

|Rating Distribution |

|Positive |0% |

|Neutral |71% |

|Negative |29% |

|Avg. Target Price |$34.00↑ |

Capital Structure/Solvency/Cash Flow/Governance/Other

At the end of 3Q06, the company had cash, cash equivalents, and investment securities and associated interest receivable of $187.8M.

On December 18, 2006, ICOS announced that an agreement has been reached to amend the terms of the merger agreement with Eli Lilly and Company (originally signed on October 16, 2006). Under the terms of the revised agreement, Lilly has raised its bid price to $34 per share from the previous offer price of $32 per share. ICOS's Board of Directors has considered and unanimously approved the revised $34 per share price and recommends that shareholders approve the revised Agreement and Plan of Merger.

Post the revised agreement, ICOS postponed its special shareholders’ meeting from December 19, 2006 to January 25, 2007.

Potentially Severe Problems

There are none other than those discussed in other sections of this report.

Long-Term Growth

The analysts believe though Cialis is likely to provide a long-term value and reach worldwide peak sales of about $1 billion, the substantial expenses associated with the JV and below-anticipated growth of the ED market may result in lower-than-expected performance.

There is an enormous amount of marketing data presented by ICOS/LLY as to why they believe Cialis is the superior drug. They highlight the top four reasons:

1. Cialis lasts in the system approximately 36 hours, whereas Viagra and Levitra last only 4-5 hours.

2. Cialis has been approved with no food interaction, whereas Viagra and Levitra both report a decrease in efficacy when taken with either large or high-fat foods.

3. Cialis has been approved with no drug/drug interactions other than contraindication to nitrates and alpha-blockers other than FLOMAX. However, the FDA recently recommended the removal of the contraindication that prevents its use with alpha-blockers. The warning will now appear in the precautionary section instead, similar to the labeling for Viagra and Levitra.

4. Cialis has been approved with no cardiovascular precaution calling out the potential for QT prolongation (heart rhythm disruption), whereas Levitra has this warning.

The analysts believe that Cialis should continue to show strong presence in overseas markets. Strong international sales growth should continue, as Cialis appears to be competing better abroad. Lilly/ICOS has been able to more effectively establish Cialis’s benefits with physicians in Europe, where doctors are much less influenced by consumer preferences than in the US. Cialis has captured nearly 35% market share outside US and is market leader in eleven countries including France, Portugal, South Africa and Saudi Arabia. However, Viagra generics are expected to enter the US market during 1H07 and are likely to greatly diminish Cialis’s erectile dysfunction opportunity. Longer term, indications outside of erectile dysfunction may provide more fertile areas for growth, but meaningful use in those indications is unlikely until late in 2010.

Upcoming Events

|Date |Event |Comments |

|Late 2006 |File for approval of low dose once daily Cialis in North |For Cialis |

| |America | |

|2006 |Initiate Phase IIb dose-ranging study for Cialis in BPH |For Cialis |

Individual Analyst Opinions

POSITIVE RATINGS

None

NEUTRAL RATINGS

J.P. Morgan – Neutral: November 3, 2006. INVESTMENT SUMMARY: Although sequential growth of 3Q06 Cialis sales in the US and in the Lilly ICOS territories outpaced expectations, the firm remains concerned about the underlying demand in the ED market. The firm would wait for reaccelerating market growth and Cialis share gains over several quarters to change its outlook on Cialis’s performance.

R W. Baird – Neutral ($34): December 18, 2006. INVESTMENT SUMMARY: The firm recommends existing shareholders to continue to hold on as this position represents a free call option.

UnionBankSwitz. – Neutral ($36): December 15, 2006. The firm has increased the target price from $32 to $36. INVESTMENT SUMMARY: The firm has maintained a Neutral rating on the stock pending uncertainty surrounding the closing price of the Lilly acquisition.

NEGATIVE RATING

McAdams – Sell ($36): December 18, 2006. INVESTMENT SUMMARY: The firm has maintained a Sell rating on the stock based on problems in the pipeline and a dissenting institutional share holder plan to vote against the LLY deal which raises the possibility of proxy war.

MorganStanley – Under weight: November 2, 2006. INVESTMENT SUMMARY: The firm expects the ED market growth to be slow in the near term and barring Cialis, the company’s product portfolio has modest BPH drug and poor hypertension drug.

Appendix-A

Analysts’ sales estimates, a consensus income statement, and EPS forecasts can be found in the file ICOS.xls.

Copy Editor: Uttara G.

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December 21, 2006

Research Associate: Varun Parwal, DBF

Editor:  Nelson Bishop, CFA

Sr. Ed.: Ian Madsen, CFA; imadsen@; 1-800-767-3771, x417

Zacks Research Digest Arpita Dutt, CA, (H) / imadsen@

Ian Madsen, MBA, CFA, Editor, 312.630.9880 x.417

155 North Wacker Drive Chicago, IL 60606

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